Many advisors are not fully aware of the powerful benefits that dividend-paying stocks can offer their clients as a planning strategy. Advisors facing the daunting task helping today’s retirement-bound clients should consider structuring retirement portfolios with increased allocations to dividend-paying equities in order to capture higher returns offered through a combination of dividends and price appreciation.
Historically, almost half of the 10 percent annual return from stocks has come from dividends, with the balance being earned through price appreciation. Over the past 10 years, the major index companies increased dividends dramatically; Dow Jones Industrial Average Index (DJIA) companiesincreased dividends by 76 percent, S&P 500 Index companies by 68 percent, and the Nasdaq Index companies by 490 percent.
This 10-year period has been a particularly dismal period for advisors and their client portfolios who suffered through a major bear market from 2000-2002, and a major financial crisis in 2008. Yet the DJIA, S&P 500 Index, and Nasdaq Index companies increased dividends by an average of 7.07 percent, 5.46 percent, and 45.38 percent respectively per year. The staggering increase in Nasdaq dividends has been driven by a dramatic increase in the number of technology companies that have adopted dividend-payout programs. These dividend statistics lead us to believe that we are entering into a Golden Age of Dividend Investing, which will save retirement for millions of Americans.
Today’s retirement planner is faced with a myriad of planning conundrums. Advisors are encountering a growing number of people who find themselves with severely diminished capital after years of saving. As they age, investors are left with less time and resources to secure a comfortable retirement. Planners also face the dual challenges of longer life spans and the potential for higher-than-average, long-term inflation. In addition, traditional retirement income sources, including pensions and social security, may not be sufficient when the time comes to cash in. All these factors may increase the burden on portfolios to produce more income at a time when yields from income-producing investments are at the lowest levels in 50 years.
Building Capital For Risk-Averse Clients
Since 2000, investors have become risk-averse after experiencing several large losses in recent bear market cycles. They are understandably reluctant to expose their remaining capital to further losses by investing in equities. Human survival instincts are genetically hardwired to spur investors to get out when the markets drop, which is a leading cause of loss when using the “buy-and-hold” approach to investing. Instead of hanging on during tough market conditions, investors’ fear can lead them to sell out of their positions. In order to help them get back invested, these fearful investors may need a responsive process that attempts to mitigate market volatility and large capital losses, instead of assurances that diversified buy-and-hold portfolios might work better in the future than they have in the past.
Now is the time for advisors to reconsider conventional passive approaches. As the risk of capital loss increases in down market cycles, dividend-paying stocks tend to be less volatile as investors become attracted to the more certain returns that quarterly dividend payments provide. When combined with a responsive methodology designed to conserve capital and prevent large losses, both advisors and their clients benefit.
Advisors and clients may not realize that recent higher dividend trends bode well for investment returns. Dividends provide a predictable source of return that pays investors to wait patiently for price appreciation and bull market conditions to return to equity markets. For retirement-bound clients who need to accumulate capital, reinvested dividends can unleash compounding and dollar-cost averaging. Adding shares when dividends are reinvested, enables clients to buy more shares each quarter. As the number of shares increases, so does the dividend payment, which drives share balances higher. Systematic investing leads to lowering the average purchase price as stocks’ share prices fluctuate. The lower the share prices, the more shares that can be purchased.
A hypothetical $10,000 invested on January 1,1947 in an investment that performed similarly to the DJIA would have grown exclusively from price appreciation to $689,479 by the end of 2011. Over the same time period, a hypothetical $10,000 invested with the combination of dividends reinvested and price appreciation would have grown to $7,007,862.
Even over a much shorter period and during the second-worst bear market in history, compounding with reinvested dividends provided positive results. A hypothetical investment of $100,000 on January 1, 2000 in an investment that performed similarly to the DJIA wouldhave grown from price appreciation to $106,266 by the end of 2011. Over thesame period of time, a hypothetical$100,000 invested with dividends would have grown to $140,821.
Longevity And Dividends Vs. Inflation
Today’s average investment horizon is about 65 years, from approximately age 25 when people begin saving, until about age 90 when investors reach life expectancy. Consequently, with today’s longer average life span, investors may need to build asset bases large enough to generate current income while also reinvesting to keep pace with inflation. Dividend-paying stocks provide retired clients with two sources of protection from inflation; one is price appreciation, which can increase capital balances, and more important one, rising dividend income streams.
Dividends Can Help Fight Inflation
From 1947 to 2011, the 3.95 percent average inflation rate, as measured by the Consumer Price Index (CPI), was more than offset by the 6.29 percent average increase in cash dividends paid by Dow Jones Industrial Average (DJIA) companies. A hypothetical investment of $1.00 in the Dow Jones DJIA from 1947 to 2011, showing the inflation fighting benefits of rising dividend payouts over multiple time periods versus $1.00 adjusted annually for increases in CPI. Readers should note, the past 65 years provides a good historical reference because it encompasses two very long-term investment cycles, including both long-term bull and bear market cycles. Over each period studied, increasing dividend income more than offset the rise in cost of living caused by CPI.
The investor population around the world is rapidly aging, and corporations have responded. Companies that have established dividend-paying programs have stepped up dividend increases to make their stocks more attractive to retirement bound investors. As a result, many companies in industry sectors that never paid dividends before are now playing catch up by not only starting dividend programs, but also providing frequent increases.
Accelerating dividends may provide income-hungry investors with a powerful ally in their fight against inflation. CPI increases have averaged approximately 2.5 percent per year since 2000, while dividend increases on the popular indexes have outpaced the increase in CPI by almost 2:1. Since 1987, dividend-payout ratios, the percentage of earnings companies payout in dividends, have averaged 47 percent for the DJIA and 37 percent for S&P 500 companies. 2011’s dividend payouts of 32 percent and 26 percent respectively seem rather modest and may indicate that companies have plenty of earning capacity to continue to increase dividends.
Growth In Share Price Has Been Low
Since the technology bubble burst in 2000, return from price appreciation has been flat compared to dividends which have been surprisingly positive through several recessions and a major financial crisis. For the first time in history, the technology sector has become the second largest dividend-paying sector in the United States.
Risk To Capital Matters
An advisor’s success may be dependent on their adoption of a risk management methodology that seeks to curb declines so investors can stay invested instead of assuming investors will ignore big losses. With heightened economic and market risk, managers also need to have constant awareness for portfolio holdings that begin to weaken. Many passive investors found out the hard way that buying and forgetting stocks can be dangerous and damaging to financial health.
We suggest managing with a dynamic trailing stop- loss process that attempts to systematically harvest gains on bonds and stocks when available (sell high) while also aiming to limit losses during negative market cycles. Adjusting the duration on bond positions in an effort to reduce rising interest rates may further mitigate bond risks. In designing a risk management process, care should be taken so that the stops and goals used result in an unemotional response to changes in risk at both the individual security level and in the overall market.
The important benefits of dividends, such as securing a steady return not dependent on price appreciation and compounding of reinvested dividends, will not be diminished materially by proposed tax increases. Advisors need to keep in mind that preferential tax treatment for dividends has only been around since2003, and before that, for most of our 65-year study, dividends were taxed at much higher ordinary income rates.
Based on market return dynamics, we strongly suggest that dividend-paying stocks, not growth stocks, should be the cornerstones of portfolio construction, especially for retired investors. The return from dividends can provide a critical source of cash flow that can be used to fund inflation-adjusted withdrawals. Reducing losses through proactive risk management combined with interest and dividend income from underlying investments is critical to reducing the potential for compound liquidation of retired investors’ capital in bear market cycles. Add in the good news regarding the current combination of rising dividend trends across a broad spectrum of stocks and relatively modest payout ratios, and we may have indeed paved the way for investors to enjoy a golden retirement because of a golden age of dividend investing.
Don Schreiber Jr., CFP, is CEO of WBI Investments, which manages $1.5 billion for advisors and their clients using a dividend paying strategy. He is also co-author of All About Dividend Investing (McGraw-Hill, 2011, 2nd Ed.).